In a recent informal guidance issued to KPIT Cummins Infosystems Ltd., SEBI has given a formal approval to the company to implement cashless exercise for its ESOP holder employees. While the SEBI ESOP guidelines do specifically provide for the cashless route, companies were apprehensive about the exact route to be followed. In that sense this guidance will pave the way for companies who are keen to follow this route.
Cashless route is the most common mode followed by companies globally to enable employees to fund the exercise price and tax obligations when they exercise their stock options. Since most companies grant options at market price, the amount of money employees have to pay while exercising is substantial and often acts as a deterrent for exercise. Few employees also seek loans to pay for the obligations. Perquisite tax which has to be paid on exercise also adds to the funding requirement.

Under the cashless route, the employee authorizes the holder of shares (typically an ESOP Trust) to sell the necessary number of shares to pay off his obligations and transfer only net shares to him. This is also referred to as “sell to cover”. In case the employee does not want to hold the shares or if he does not have a demat account (typically an overseas employee), he may authorize the Trust to sell all the shares vested in him and give him the net proceeds after adjusting the exercise price and tax obligations. This is also called “same day sale” in the US where more than 80% of the exercises are of this nature.

Formal nod from SEBI for this mechanism is a big step forward in making the cash realization process much simpler for the employee. For the risk-averse employees, it also does away with the need to borrow money for exercising.

Another major aspect covered by this guidance from SEBI is about the use of Trust to implement this route and the implications with respect to Insider Trading guidelines for the Trust and Trustees (who often are “Insiders”).
In one of the earlier guidance (issued to Mukta Arts Ltd.), SEBI had clarified that if the Trustees of the Trust are designated as Insiders by the company, the Trust will have to comply with the Insider Trading guidelines and will be subject to the requirements around disclosures, adherence to black out period, restriction on entering into an opposite transaction (sale followed by a purchase or vice versa) within 6 months, prior approval before selling shares and so on. Subsequently SEBI issued a clarification that the restrictions on entering into an opposite transaction will apply only if the shares acquired by the Trust are existing shares and not fresh shares (primary) issued by the company.

In the guidance issued to KPIT, while SEBI has re iterated that the restriction on opposite transaction will not apply to the Trust, since the shares acquired by the Trust are primary shares, it has also allowed the company to allot shares to the Trust prior to the exercise of options. In other words, when the employee exercises his options, the underlying shares are already allotted and listed and can be sold on the same day of exercise. Currently in the best case scenario this process takes anywhere between 30 to 45 days. First time lag is between exercise and allotment of shares and second between allotment and listing of shares. This not only leads to delay in the realization of cash but the employee is also exposed to financial risk (if he has borrowed) and market risk (prices could fall between the exercise date and date when he gets tradable shares). With cashless route this time lag can be brought down to 2-3 days.

Ultimate test for any ESOP plan to be successful and meaningful is in how easy is the cash realization process for the employee. Cashless exercise is a big step in that direction. Given the current volatile market movements which are expected to continue for the next few quarters, this guidance could not have come at a better time.

As thought leaders and pioneers in the Equity compensation area, we at ESOP Direct are pleased to have conceptualized and designed this process and obtain the regulatory nod.

For more details /clarifications please contact Harshu Ghate, Co-founder and CEO, ESOP Direct at harshu@esopdirect.com